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Yesterday India's central bank (the RBI) imposed what amounts to a form of currency controls, while trying to attract foreign deposits.

Bloomberg: - The RBI cut the amount local companies can invest overseas without seeking approval to 100 percent of their net worth, from 400 percent, according to a statement on Aug. 14. Residents can remit $75,000 a year versus the previous limit of $200,000.

The authority said banks accepting deposits after Aug. 24 from Indians living abroad need no longer keep 4 percent of the funds in cash and invest 23 percent in government-approved securities.

India also boosted import duties on bullion on Aug. 13 and banned inward shipments of gold in the form of coins and medallions to reduce the trade deficit. In a briefing in New Delhi on Aug. 14, Mayaram said imported gold must be stored in government-mandated warehouses.

It didn't do any good. Driven by expectations of impending exit from QE3 in the US, the rupee punched through 62 this morning, hitting a new all-time low.

Sober Look

Rupees per $1 (source: Investing.com)

At these levels inflation will soon become a concern. Investors continued dumping short-term government bills, with the 6-month paper going above 11% for the first time.

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India 6-month government bills (yield)

The stock market, which has all but ignored India's currency crisis, tumbled 4% today. The reality of the situation is finally setting in.

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India's broadly watched stock index (SENSEX)

The retreat across capital markets was exacerbated by escalating tensions with Pakistan.

The Times of India: - Using heavy calibre guns, Indian Army retaliated strongly after Pakistani troops on Thursday resorted to unprovoked and indiscriminate firing with rocket and mortar shell attacks at LoC posts in Jammu & Kashmir's Poonch sector that injured three Army jawans and a civilian.

This is the 11th ceasefire violation by Pakistan in the past five days, Army officials said.

As capital outflows continue, India is struggling to plug its widening current account gap (6.7% of GDP last year). This has become the worst economic crisis for the nation since 1991, when India's government, faced with depleted foreign reserves, had to resort to asking the IMF for help. At the time, the country had secured a $2.2bn loan, backed by 67 tons of gold reserves. To satisfy the IMF's concerns about access to the collateral, the RBI had to airlift 47 tons of gold to be deposited offshore with the Bank of England and 20 tons of gold with UBS.

While such action is unlikely this time around, if the crisis continues to escalate, Asia's third largest economy will struggle to grow. Even though economists still do not expect a contraction, it is now a real possibility. Some weakening of the rupee may have been desirable for exporters, but losing control of the exchange rate was not what the RBI had in mind.